Trichet Faces ‘Annus Horribilis’ as Crisis Tests ECB

Jean-Claude Trichet, president of the European Central Bank (ECB). Photographer: Denis Doyle/Bloomberg

Jan. 13 (Bloomberg) -- Jean-Claude Trichet’s final year at
the helm of the European Central Bank may be his toughest yet as
widening economic divergences within the euro area strain the
bank’s one-size-fits all monetary policy.

With the sovereign debt crisis threatening to engulf
Portugal and bond yields in debt-strapped nations near euro-era
highs, Trichet must decide when to stop buying government
assets, withdraw unlimited liquidity provision for banks and
possibly even raise interest rates to stem inflation risks. His
response to those challenges may shape his legacy by helping to
determine the euro’s future.

“2011 could be another annus horribilis for the ECB,”
said Ken Wattret, chief euro-area economist at BNP Paribas in
London. “Stress in debt markets hasn’t diminished and the
divergence between euro-area countries is getting bigger. It’ll
be a big challenge for the ECB and a tough job for its president
to negotiate an appropriate path for monetary policy.”

Trichet, who chairs an ECB policy meeting today, has been
forced to take unprecedented steps to buy time for the euro as
governments struggle to agree on how best to shore up confidence
in the monetary union. The decision to buy government bonds
split the ECB’s Governing Council, and some policy makers have
warned that price stability, the bank’s primary goal, could be
compromised if emergency measures are left in place too long.

Policy Meeting

Inflation quickened to 2.2 percent last month, breaching
the ECB’s 2 percent limit. The ECB’s 23-member council will
nevertheless keep its benchmark interest rate at a record low of
1 percent today, according to all 53 economists in a Bloomberg
News survey.

The decision is due at 1:45 p.m. in Frankfurt and Trichet
holds a press conference 45 minutes later. The Bank of England
kept its key rate at 0.5 percent today.

Euro-area economies are diverging as the debt crisis damps
growth in peripheral countries while northern European nations
such as Germany power ahead.

Portugal may join Greece and Ireland in receiving European
Union aid as part of a package of new measures being discussed
by governments to quell the crisis, according to four people
with direct knowledge of the talks.

Bond Auctions

Spanish 10-year bond yields decreased nine basis points to
5.34 percent as of 12:15 p.m. in Frankfurt after investor demand
in a five-year debt auction increased from November. Spain will
pay an average yield of 4.542 percent on the new securities, up
from 3.576 percent.

Italian borrowing costs increased to 3.67 percent at a sale
of five-year securities today from 3.24 percent the last time
they were sold on Nov. 12.

The German economy grew 3.6 percent last year, the most in
two decades, the country’s statistics office said yesterday. By
contrast, the Greek, Irish and Spanish economies shrank,
according to European Commission estimates. Portugal’s is
forecast to contract this year.

That’s making it harder for the ECB to determine when to
exit from its emergency measures, and to set its “one-size-fits-all” monetary policy.

While the ECB describes its bond purchases and liquidity
injections as “temporary,” it has repeatedly been forced to
delay their withdrawal as the crisis intensified. Last month it
said it will keep liquidity measures in place through the first
quarter.

Inflation Risk

Continuing to pump cheap cash into the banking system risks
fueling inflation in the longer term, yet withdrawing the
measures too soon could frighten markets and push up the
interest rates stricken nations have to pay on their debt,
exacerbating the crisis.

By the same token, if the ECB keeps its key interest rate
at a record low for too long as it tries to support struggling
economies, it may stimulate too much growth in Germany and drive
up prices there.

German inflation unexpectedly accelerated to 1.9 percent
last month, pushing the euro-area rate above the ECB’s 2 percent
limit for the first time in more than two years.

“The inflation outlook has worsened considerably,” said
Klaus Baader, co-chief euro-region economist at Societe Generale
in London. “If the inflation rate overshoots 2 percent for a
few months that’s not a problem, but the question arises whether
inflation expectations will remain anchored.”

Political Jockeying

The ECB will raise its benchmark rate in the fourth quarter
of this year, according to a Bloomberg survey of economists. It
would be the first policy tightening in more than three years
and Trichet, whose term ends on Oct. 31, may leave the task to
his successor.

Political jockeying for the job started more than a year
ago, when heads of government chose Vitor Constancio of Portugal
to be the ECB’s new vice president. It may enter another round
when governments decide on a replacement for Austria’s ECB
Executive Board member Gertrude Tumpel-Gugerell, whose term
expires in May.

The next ECB president “will have to be someone who
carries some serious weight, but also some diplomatic skills,”
said Elga Bartsch, chief European economist at Morgan Stanley in
London. “This combination is a rather rare one.”

Leading Contender

Bundesbank President Axel Weber, a leading contender to
take over from Trichet, has broken ranks with his ECB colleagues
and annoyed some politicians by opposing the bank’s bond
purchases.

Italy “would be honored” if its central bank governor,
Mario Draghi, became the next ECB president, Prime Minister
Silvio Berlusconi said in Berlin yesterday during a joint press
conference with German Chancellor Angela Merkel.

Luxembourg’s Jean-Claude Juncker, who heads the group of
euro-area finance ministers, said on Jan. 4 that EU leaders may
not take a decision on Trichet’s successor until October.

For his part, Trichet has warned governments not to rely on
the ECB to solve the debt crisis and urged them to take greater
responsibility for fiscal imbalances. The bank’s policies
“cannot substitute for government irresponsibility,” he said
last week.

“Each year has thrown up a new set of acute challenges and
this one isn’t going to be an easy one for Trichet either,”
said Julian Callow, chief European economist at Barclays Capital
in London. “Until his last day in office he’ll be trying to
shepherd the euro area into calmer waters.”